Download Low interest rates provide a stimulus but can also create risks

Low interest rates provide a
stimulus but can also create risks
9 JUN 2015 3:00 PM • BANK OF FINLAND BULLETIN 2/2015 • FINANCIAL STABILITY •
KIMMO KOSKINEN, KATJA TAIPALUS
• Kimmo Koskinen
Senior Economist
• Katja Taipalus
Head of Department
Accommodative monetary policy is necessary for price stability and economic recovery.
However, abundant liquidity and the search for yield fuelled by low interest rates can
also create risks for financial stability.
Accommodative monetary policy is necessary
Economic developments in the euro area have been subdued, albeit there are differences
across countries. The European Central Bank (ECB) has pursued its inflation objective
and supported economic recovery by holding interest rates at a low level and ensuring
the availability of liquidity for banks. Despite these efforts, high levels of private and
public sector debt are hampering economic recovery: borrowing is not attractive because
debt burdens have remained high.
Banks central to monetary policy transmission
Low interest rates due to the relaxed monetary policy stance support the availability of
market funding as an alternative to bank-based funding. At the same time, they also
support acquisition of funding by banks themselves. However, even this better access to
funding by banks has not increased bank lending as hoped.
The latest statistical data[1] indicate that lending to the private sector by euro area banks
has remained muted. The annual growth rate of lending to the private sector in the euro
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area was in fact 0.0% in April 2015. However, country-specific differences in lending are
fairly substantial. The ECB’s Bank Lending Survey (BLS) suggests that banks’
expectations about credit developments are improving. Banks expect the ECB’s expanded
asset purchase programme (EAPP), in particular, to support lending growth in the
future.
The BLS indicates that the EAPP has already improved banks’ liquidity position and
reduced their funding costs. At the same time, margins on loans to the private sector
have narrowed, especially in southern Europe. The exceptionally low level of interest
rates is, however, exerting further downward pressures on banks’ net interest income.
Banks that participated in the BLS expected their profitability to weaken on average over
the next six months (Chart 1).
Chart 1.
ECB Bank Lending Survey and effects of the EAPP
on the financial situation of euro area banks
1.
2.
60
Past six months
Next six months
Net percentages
1
2
40
20
0
–20
Total
assets
Liquidity
position
Market
financing
conditions
Profitability
Capital
ratio
Leverage
ratio
Above zero = situation improving.
Below zero = situation deteriorating.
Source: European Central Bank.
6 May 2015
bofbulletin.fi
Record reliance by corporations on market-based
funding
The proportion of market-based funding in debt financing has grown recently, providing
a necessary alternative to bank lending. Tighter bank regulation, digitalisation and
persistently low interest rates are changing the competitive situation between banks and
other actors in financial intermediation (see article ‘Major changes underway in
European banking sector’).
Low interest rates have encouraged investors to search for yield through riskier products.
The search for yield has actually helped to improve the functioning of the financial
markets. Higher demand has raised stock prices – in some cases quite significantly – and
reduced bond yields. Large corporations, in particular, have taken advantage of the low
interest rates by issuing a record volume of bonds since the financial crisis. At the
1. European Central Bank, Balance Sheet Items statistics (BSI), 29 May 2015.
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beginning of 2015, the stock of corporate bonds in the euro area exceeded EUR 1,000
billion (Chart 2). This represents growth of as much as 80% from the end of 2008. In
particular, institutional investors such as investment funds, private and public pension
funds and insurance companies have increased their investments in corporate bonds.
Chart 2.
Corporate loans granted by euro area banks,
corporate bonds issued in euro area and
relation of corporate bonds to bank loans
1.
2.
3.
6,000
Corporate bond issuances (left-hand scale)
Corporate loans granted by banks (left-hand scale)
Stock of corporate bonds relative to bank loans (right-hand scale)
EUR billion
%
3
5,000
30
25
2
4,000
20
3,000
15
2,000
10
1,000
5
1
0
0
1999
2010
2011
2012
2013
2014
Source: European Central Bank.
6 May 2015
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Particular concern has been caused by the strong growth in issuance of high-yield
corporate bonds and the historically low level of required returns and risk premia. The
volume of euro-denominated bonds issued by high-risk corporations in Europe has
already grown to around EUR 250 billion,[2] or about 25% of the corporate bond stock
(Chart 3). Low interest rates and investor hunger for yield have maintained demand for
these products, and risk premia have been declining in the early months of 2015.
A rise in interest rates could cause significant losses, especially to those who have
invested in high-yield corporate bonds. Changes in investors’ risk resilience could also
endanger funding acquisition for many companies by increasing costs as interest rates
rise and the provision of funding declines. The implications could be significant,
particularly when considering that the banking sector has strongly reduced the amount
of riskier corporate bonds on their balance sheets.
2. Barclays.
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Chart 3.
Euro denominated high-yield corporate bonds
issued in Europe and their option adjusted risk
premia according to credit rating
1.
2.
3.
4.
5.
35
Total Europe (left-hand scale)
BB (left-hand scale)
B (left-hand scale)
CCC (left-hand scale)
High-yield bonds, stock (right-hand scale)
EUR billion
% points
30
5
280
240
25
200
20
160
15
120
4
10
0
80
3
1
2
5
2009
2010
2011
2012
2013
2014
2015
40
0
Bonds of high-risk corporations (excl. financial corporations).
Source: Barclays.
6 May 2015
bofbulletin.fi
From the perspective of financial stability, it is essential to monitor the growth and
changes in corporate bond financing and other funding acquired outside of the banking
sector (see article ‘Major changes underway in European banking sector’). In assessing
the success of policy action to stimulate the economy, it is important to examine where
funding is channelled: in order to support economic growth, funding should be
channelled primarily into productive investment, not just to financial instruments.
Search for yield can distort prices
There are fears that equity and bond prices, in particular, and partly also real estate
prices on the international financial markets have already exceeded the level supported
by economic fundamentals. Investor search for yield has increased demand for high-risk
instruments. This has created fertile ground for the development of various financial
innovations. Innovations reallocate risks and create new linkages between the various
actors in the financial system. In order to mitigate uncertainties about the reallocation of
risks in times of disruption, new innovations must also be sufficiently transparent.
Even though there are fears of overheating on the markets, it is hard to detect
unambiguous signs of an overvaluation of asset prices. However, in the United States, for
example, there is a general fear that equity market valuations are already too high
relative to the economic fundamentals.
Equity valuations can be analysed through various early warning indicators. However,
the signals given by such indicators should be interpreted with caution. Several different
tools need to be analysed before drawing conclusions about overvaluation on the equity
markets. At present, many of the early warning indicators are already providing signals
of elevated stock prices, including in relation to dividends on stocks (Charts 4 and 5).
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From the perspective of financial stability, therefore, it is necessary to monitor whether
the indicators continue to give signals of price overheating going forward.
Chart 4.
Signals of overheating on US equity markets:
stock prices 31 May 1903 – 31 March 2015
1.
2.
3.
T price signal* of too high prices
PSY price signal** of too high prices
S&P 500 index
Point scale
2,500
2,000
1,500
2
1,000
3
500
1
0
1903 1913 1923
1933 1943 1953 1963 1973 1983 1993 2003 2013
* For the construction of the T-signal, see Taipalus, Katja (2012) Detecting
asset price bubbles with time series methods. Bank of Finland Scientific
monographs, E:47.
** For the construction of the PSY-signal, see Phillips, Peter C.B. –
Wu, Yangru – Yu, Jun (2009) Explosive behavior in the 1990s
NASDAQ: When did exuberance escalate asset values? International
Economic Review, 52:201.
Sources: Bloomberg and calculations by the Bank of Finland.
6 May 2015
bofbulletin.fi
Chart 5.
Signals of overheating on US equity markets:
stock prices 31 May 1903 – 31 March 2015
1.
2.
3.
2,500
T dividend signal* of too high prices relative to dividend flows
PSY dividend signal** of too high prices relative to dividend flows
S&P 500 index
Point scale
2,000
1
2
1,500
1,000
500
3
0
1903 1913 1923
1933 1943 1953 1963 1973 1983 1993 2003 2013
* For the construction of the T-signal, see Taipalus, Katja (2012) Detecting
asset price bubbles with time series methods. Suomen Pankki, E:47.
** For the construction of the PSY signal, see Phillips, Peter C. B. –
Wu, Yangru – Yu, Jun (2009) Explosive behavior in the 1990s NASDAQ:
When did exuberance escalate asset values? International Economic
Review, 52:201.
Sources: Bloomberg and calculations by the Bank of Finland.
6 May 2015
bofbulletin.fi
Tags
• overheating
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• financial intermediation
• interest rates
Authors
Kimmo Koskinen
Katja Taipalus
Senior Economist
Head of Department
firstname.lastname(at)bof.fi
firstname.lastname(at)bof.fi
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